The U.S. Supreme Court held that the 40% penalty for a gross
valuation misstatement applied when the partnerships at issue had been
determined to be shams that lacked economic substance, and, as a
result, the partners’ outside basis in the partnerships was zero (Woods,
No. 12-562 (U.S. 12/3/13), rev’g 471 Fed. Appx. 320 (5th Cir. 2012)).

The decision resolved a split among the circuit courts, with most
courts holding that the penalty applied. The Fifth Circuit, in which
this case originated, and the Ninth Circuit have held that the penalty
does not apply when the entire transaction is disregarded on economic
substance grounds. It also addressed a disagreement among the courts
over whether district courts have jurisdiction to determine whether
the penalty applies in a partnership-level proceeding.

In this case, two taxpayers took part in a tax shelter called COBRA.
The tax shelter generated large paper losses that the taxpayers sought
to use to offset taxable income. The shelter artificially inflated the
taxpayers’ outside bases in two partnerships, which ultimately allowed
the taxpayers to claim losses many times greater than the amount of
their investment.

In a unanimous opinion written by Justice Antonin Scalia, the Court
explained that a substantial-valuation-misstatement penalty of 20%
applies under Sec. 6662 to any portion of an underpayment attributable
to a substantial valuation misstatement. Under the version of Sec.
6662 then in effect, if the reported value or adjusted basis of a
property exceeded the correct amount by at least 400%, the 20% penalty
increased to 40%. (The current threshold is generally 200% of the
correct amount.) Under Regs.
Sec. 1.6662-5(g), if property is found to have a basis of zero,
the 40% penalty applies.

The taxpayer argued against the penalty primarily on the grounds that
value and valuation are factual, rather than legal, issues and that
the penalty applies to factual misrepresentations of an asset’s worth
or cost, not to legal determinations of whether a partnership existed.
The Court, however, was not convinced that value was strictly a
factual issue, and it further noted that the penalty also refers to
adjusted basis, which “plainly incorporates legal inquiries.”
Therefore, the Court held that the valuation-misstatement penalty
encompasses legal as well as factual issues.

In the alternative, the taxpayer argued, as the Fifth and Ninth
Circuit had held in prior cases, that any underpayment of tax in this
case would be attributable not to the misstatements of outside basis
but rather to the determination that the partnerships were shams,
which was an independent legal ground. In rejecting this argument,
Scalia quoted a concurring opinion in a Fifth Circuit decision,
stating that, with the type of tax shelter at issue, “the basis
misstatement and the transaction’s lack of economic substance are
inextricably intertwined, so attributing the tax underpayment only to
the artificiality of the transaction and not to the basis
overvaluation is making a false distinction” (slip op. at 15–16,
quoting Bemont Investments, LLC, 679 F.3d 339, 354 (5th Cir.
2012)).

The Court also found that the district court had jurisdiction to
determine whether the penalty applied in the partnership-level
proceeding. The taxpayer argued that the issue of the partners’
outside basis in their partnership interests was not a
partnership-level item that fell under unified audit provisions in the
Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), P.L. 97-248.
But the Court agreed with the IRS that the TEFRA partnership rules
would be undermined if penalties could be determined only at the
partner level rather than at the partnership level.

TAX NEWS

President Barack Obama signed legislation that retroactively extended more than 50 expired tax provisions for 2014, allowing taxpayers to take advantage of a host of tax incentives during this filing season.

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